You've just endured the worst two months in the past 58 years for U.S. financial markets. I'm sure you knew things were bad, but let me give you some hard facts to back up what you're feeling right now:
Of the 30 worst trading days since 1950, a full nine of them (30%) occurred this past September and October. That 9% drop we saw in early October was the second-worst trading day since the early part of the last century.
Yet despite the turmoil, you're still reading about stocks that interest you, and hopefully investing more money in the best of the bunch. You do so not out of some perverse masochistic impulse, but because it makes sense. You know that when stocks go on sale, it's time to cash in on those market panic coupons and go shopping.
We've seen this before … almost
The only year that comes close to rivaling the precipitous drops in recent memory was 1987. That year stakes its claim to five of the worst trading days since 1950, including the so-called Black Monday crash of October 1987, which erased more than 20% from the S&P. But even that drop turned out to be a blip, albeit an incredibly large one, on an otherwise tremendous nearly two-decade bull market run for stocks.
Will we look back on September and October 2008 as another bump on the long road to prosperity? I won't make a market prediction for the next year, or even two years, but valuations have improved considerably in recent months, and there are some successful long-term investors who share that sentiment.
Don't be afraid of value
Marty Whitman, legendary value investor and manager of the Third Avenue Value Fund, had this to say about current opportunities: "Safe and cheap [investing] on a long-term basis seems to be about as attractive at it was in the 1970s." He's also been snapping up shares of prominent companies whose valuations had been crushed, such as Sears Holdings (Nasdaq: SHLD ) and Ambac Financial (NYSE: ABK ) . The S&P has fallen another 28% since he made that statement, so I'm confident this asset hound has become even more optimistic.
John Hussman, value investor and self-proclaimed "perma-bear," thinks current valuations are attractive. Hussman's Strategic Growth Fund has achieved cumulative growth of 116% since its inception in July 2000, versus a 25% loss for the S&P. Hussman was able to more than double the value of his fund largely by avoiding market exposure.
Now, for the first time in more than five years, Hussman believes current valuations are blatantly attractive. He recently noted that "relative to the 30-year Treasury yields, the S&P 500 is priced to deliver the highest excess return since the early 1980s." Remember, the early 1980s marked the beginning of the greatest wealth creation in our nation's history.
Don't be afraid of volatility
Even though valuations are much more attractive now than they were this time last year, financial markets will remain volatile in the coming months. But if you have the discipline and willingness to search for companies that are unjustifiably cheap, I believe you will reap handsome rewards five to 10 years from now.
So how do you keep your wits about you and invest in long-term winners? As a research analyst with our small-cap Motley Fool Hidden Gems service, I look for companies that possess
- Strong balance sheets
- Wide moats
- Room to grow
Strong balance sheets
Much of the hysteria in the market these days centers on the lack of access to capital. Companies that can internally fund their growth, or have enough cash to withstand a severe recession, should be at the top of your list. I recently added children's retailer Gymboree to our watch list. The company has absolutely no debt and plenty of cash on its balance sheet. It may not grow earnings at 20% for the next two or three years, as it has in the past. But it has a strong enough financial position to ride out a slow economy.
Chipotle (NYSE: CMG ) has a similar story. Although reduced consumer spending will likely herald slower revenue growth than last year's heady rate of 32%, the company continues to fund its incredibly profitable new stores with the cash its business generates. The balance sheet carries almost no debt, and Chipotle has enough excess cash to comfortably fund a $100 million stock buyback.
Companies with wide moats offer products or services that are extraordinarily difficult for a competitor or start-up to emulate. For example, Warren Buffett's Berkshire Hathaway (NYSE: BRK-A ) was able to obtain sweetheart deals with two of the most respected and recognized companies in the world, Goldman Sachs (NYSE: GS ) and General Electric (NYSE: GE ) . Few, if any, other companies have the balance sheet and reputation to knock on the doors of such stalwarts and receive a guaranteed 10% return, plus the potential for much more when the shares recover. These sorts of companies can earn excess returns for investors over a sustained period of time.
Room to grow
Though emerging markets have been pummeled this year, some well-run companies will undoubtedly benefit as countries like Brazil, Russia, India, and China continue to advance. Foreign-based companies should certainly play a role in any diversified portfolio. But there are also a number of U.S.-based firms that also have strong footprints in these growth regions.
Coca-Cola (NYSE: KO ) is a terrific example of a large U.S. company that has managed to maintain healthy growth by tapping into emerging economies. Coke generates an increasing majority of its revenue from countries outside of Europe and the U.S. The company recently announced double-digit earnings growth that was driven primarily by strong revenue growth in emerging markets.
Invest like it's 1987
Due to present fear-induced valuations, investors who demand these three must-haves from their investments stand an excellent chance of generating healthy returns over the long haul.
Unfortunately, discipline is perhaps the most difficult quality to develop on the road to becoming a great investor. As much as our brains draw on empirical data and the lessons of great investors, our emotions grab at headlines, euphoria, and -- more recently -- panic selling, when making decisions.
At Hidden Gems, we will never profess expertise at calling market bottoms or tops. In fact, we're skeptical of any who do. But we do know that proven investors with a demonstrated aptitude for consistently beating the market are shouting that stocks are cheap right now.
We plan to listen to them, and to continue investing in companies that possess the aforementioned qualities. Such companies will lead the market higher when the inevitable turnaround comes -- just as they did when small caps leapt 23% after the roller coaster of 1987. You should try us out free for 30 days, and have a look at the small caps we believe the market is grossly undervaluing at the moment.
Click here for more information about a free trial.
Keith Beverly, a Motley Fool Hidden Gems analyst, owns shares of Third Avenue Value, Hussman Strategic Growth, and Gymboree. Coca-Cola and Sears are Inside Value recommendations. Chipotle is both a Rule Breakers and Hidden Gems pick. The Fool has a disclosure policy.